QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018

or

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

COMMISSION FILE NO. 0-26224

INTEGRA LIFESCIENCES HOLDINGS CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE

51-0317849

(STATE OR OTHER JURISDICTION OF

INCORPORATION OR ORGANIZATION)

(I.R.S. EMPLOYER

IDENTIFICATION NO.)

311 ENTERPRISE DRIVE

PLAINSBORO, NEW JERSEY

08536

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

(ZIP CODE)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (609) 275-0500

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer

x

Accelerated filer

o

Non-accelerated filer

o

Smaller reporting company

o

Emerging growth company

o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No ý

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes o No ý

The number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of October 30, 2018 was 85,179,535.

In the opinion of management, the September 30, 2018 unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the financial position, results of operations and cash flows of the Company. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2017 included in the Company’s Annual Report on Form 10-K. The December 31, 2017 consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. Operating results for the three- and nine-month periods ended September 30, 2018 are not necessarily indicative of the results to be expected for the entire year.

The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent liabilities, and the reported amounts of revenues and expenses. Significant estimates affecting amounts reported or disclosed in the consolidated financial statements include allowances for doubtful accounts receivable and sales returns and allowances, net realizable value of inventories, valuation of intangible assets including amortization periods for acquired intangible assets, discount rates and estimated projected cash flows used to value and test impairments of long-lived assets and goodwill, estimates of projected cash flows and depreciation and amortization periods for long-lived assets, computation of taxes, valuation allowances recorded against deferred tax assets, the valuation of stock-based compensation, valuation of derivative instruments, valuation of pension assets and liabilities, valuation of contingent liabilities, the fair value of debt instruments and loss contingencies. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the current circumstances. Actual results could differ from these estimates.

Equity Offering

In May 2018, the Company commenced and closed on a public offering of common stock. The Company issued 6.0 million shares of common stock and received total proceeds, net of underwriting fees and offering expenses, of approximately $349.6 million. The net proceeds from the offering were used to reduce outstanding borrowings under the revolving credit portion of the Company's Senior Credit Facility.

Recently Issued Accounting Standards

In May 2014, the FASB issued Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should 1) identify the contract(s) with a customer, 2) identify the performance obligations in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract, and 5) recognize revenue when (or as) the entity satisfies a performance obligation. This update became effective for all annual periods and interim reporting periods beginning after December 15, 2017. The Company adopted Topic 606 as of January 1, 2018 using the modified retrospective method. See Note 3, Revenues from Contracts with Customers, for further details.

In February 2016, the FASB issued Update No. 2016-02, Leases (Topic 842). Under current accounting guidance, an entity is not required to report operating leases on the balance sheet. The amendment requires that lessees recognize virtually all of its leases on the balance sheet by recording a right-of-use asset and lease liability (other than leases that meet the definition of a "short-term lease"). This update will become effective for all annual periods and interim reporting periods beginning after December 15, 2018. The new standard must be adopted using a modified retrospective transition. Early adoption is permitted. While the Company has not yet completed its assessment, the adoption of this guidance could have a material impact on the Company's financial position.

In August 2016, the FASB issued Update No. 2016-15, Classification of Certain Cash Receipts and Cash Payments. The guidance addresses the classification of cash flows related to debt repayment or extinguishment costs, settlement of zero-coupon debt instruments or debt instruments with coupon rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after business combinations, proceeds from the settlement of insurance claims and

corporate-owned life insurance, distributions received from equity method investees and beneficial interests in securitization transaction. This update became effective for all annual periods and interim reporting periods beginning after December 15, 2017. The Company adopted ASU 2016-15 effective January 1, 2018 on a retrospective basis. The adoption of this guidance had no significant impact on the Company's consolidated financial statements.

In October 2016, the FASB issued Update No. 2016-16, Intra-Entity Transfers of Assets Other Than Inventory. The guidance requires that the income tax consequences of intra-entity transfers of assets other than inventory be recognized as a current-period income tax expense or benefit and removes the requirement to defer and amortize the consolidated tax consequences of intra-entity transfers. The new standard became effective for all annual periods beginning after December 15, 2017. The Company adopted ASU 2016-16 effective January 1, 2018, and this guidance had no significant impact on its consolidated financial statements.

In March 2017, the FASB issued Update No. 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The guidance requires that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items were to be used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items is/are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. In addition, the amendments also allow only the service cost component to be eligible for capitalization when applicable. The new standard became effective for annual periods beginning after December 15, 2017. The Company adopted ASU 2017-07 effective January 1, 2018. The Company recognized the components of net periodic benefit cost other than the service cost component in other (expense) income, net in the consolidated statements of operations. The adoption of this guidance had no significant impact on the Company's consolidated financial statements.

In May 2017, the FASB issued ASU 2017-09, Stock Compensation (Topic 718): Scope of Modification Accounting. The update serves to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, Compensation-Stock Compensation, to a change to the terms or conditions of a share-based payment award. The new standard became effective for all annual periods beginning after December 15, 2017. The Company adopted ASU 2017-09 effective January 1, 2018, and there was no significant impact of this guidance on its consolidated financial statements.

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This update amends the hedge accounting rules to simplify the application of hedge accounting guidance and better portray the economic results of risk management activities in the financial statements. The guidance expands the ability to hedge non-financial and financial risk components, reduces complexity in fair value hedges of interest rate risk, eliminates the requirement to separately measure and report hedge ineffectiveness, as well as eases certain hedge effectiveness assessment requirements. This update will become effective for all annual periods and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. The Company elected to early adopt ASU 2017-12 effective January 1, 2017 using the modified retrospective method. The implementation of the amended guidance did not have a significant impact on the Company's consolidated financial statements.

In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects From Accumulated Other Comprehensive Income. This amendment allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the 2017 Tax Act (as defined in Note 11, Income Taxes). This guidance is effective for annual and interim periods beginning after December 15, 2018. Early adoption is permitted. The Company elected to early adopt the ASU 2018-02 effective January 1, 2018, which resulted in the reclassification of $0.5 million from accumulated other comprehensive loss to retained earnings related to a net unrealized loss on cash flow hedges.

In July 2018, the FASB issued ASU Number 2018-09, Codification Improvements. This update provides clarification, corrects errors in and makes minor improvements to the Codification within various ASC topics. Many of the amendments in this update have transition guidance with effective dates for annual periods beginning after December 15, 2018, and some amendments in this update do not require transition guidance and are effective upon issuance of this update. The Company will adopt amendments as they become applicable and has determined that the impact of these improvements will not be material to its consolidated financial condition and results of operations.

In July 2018, the FASB issued ASU Number 2018-11, Leases (Topic 842): Targeted Improvements. This update provides entities with an additional and optional transition method to adopt ASU Number 2016-02 with a cumulative-effect adjustment in the period of adoption. This update also provides guidance for a practical expedient that permits lessors to not separate non-lease components from the associated lease components. Additionally, in July 2018, the FASB issued ASU Number 2018-10, Codification Improvements to Topic 842, Leases. This update provides additional guidance on the new lease model with

improvements in numerous aspects of the guidance in ASC 842 including, but not limited to, implicit rates, reassessment of lease classification, terms and purchase options, investment tax credits, and various other transition guidance. These updates will be adopted concurrently with ASU Number 2016-02. While the Company has not yet completed its assessment, the adoption of this guidance could have a material impact on the Company's financial position.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement. The new guidance modifies the disclosure requirements related to fair value measurements in Topic 820, Fair Value Measurement, including removing certain previous disclosure requirements, adding certain new disclosure requirements, and modifying certain other disclosure requirements. The ASU will be effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. The Company elected to early adopt ASU 2018-13 on October 1, 2018. The adoption is not expected to have a material impact on the Condensed and Consolidated Financial Statements.

In August 2018, the FASB issued ASU 2018-14, Compensation-Retirement Benefits-Defined Benefit Plans-General (Subtopic 715-20): Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans. The new guidance modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans, including removing certain previous disclosure requirements, adding certain new disclosure requirements, and clarifying certain other disclosure requirements. The ASU will be effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. Early adoption is permitted. The adoption is not expected to have a material impact on the Condensed and Consolidated Financial Statements.

There are no other recently issued accounting pronouncements that are expected to have any significant effect on the Company's financial position, results of operations or cash flows.

On October 2, 2017, upon the terms and subject to the conditions set forth in the asset purchase agreement entered into by the Company with DePuy Synthes, Inc., a Delaware corporation (“DePuy Synthes”), a wholly owned subsidiary of Johnson & Johnson (the "Purchase Agreement"), the Company completed the acquisition of certain assets, and assumed certain liabilities of Johnson & Johnson’s Codman Neurosurgery business (the "Codman Acquisition"). Under the terms of the Purchase Agreement, the Company paid an aggregate purchase price of $1.014 billion, subject to adjustments set forth in the Purchase Agreement relating to the book value of inventory transferred to the Company at the closing of the Codman Acquisition. The book value of certain inventory retained by DePuy Synthes will be transferred to the Company in the future along with certain prepaid taxes.

The Codman Acquisition was accounted for using the acquisition method of business combination under ASC 805, Business Combinations. This method requires that assets acquired and liabilities assumed in a business combination be recognized at their fair values as of the acquisition date. During the third quarter of 2018, the Company completed the purchase accounting for the Codman Acquisition.

The Company recorded revenue for Codman Neurosurgery of approximately $78.9 million and $236.0 million in the condensed consolidated statements of operations and comprehensive income for the three and nine months ended September 30, 2018. The net income or loss attributable to this acquisition cannot be identified on a stand-alone basis because it is in the process of being integrated into the Company's operations.

The following table summarizes the final fair values of the assets acquired and liabilities assumed at the acquisition date and reflects measurement period adjustments subsequent to the acquisition date:

Final

Valuation

Weighted Average Life

(Dollars in thousands)

Inventory

$

74,962

Assets held for sale

30,813

Other current assets

8,202

Property, plant and equipment

41,339

Intangible assets:

Codman corporate trade name

162,900

Indefinite

Completed technology

375,200

22 years

Goodwill

342,322

Total assets acquired

1,035,738

Accrued expenses

1,730

Pension liabilities

19,917

Net assets acquired

$

1,014,091

During the first three quarters of 2018, the Company received cash of $26.7 million from Depuy Synthes related to working capital adjustments, which was recorded within investing activities on the consolidated statements of cash flows.

The Company recorded measurement period adjustments to goodwill totaling $4.0 million. During the first half of 2018, the Company adjusted goodwill by $3.2 million because of working capital adjustments of $6.2 million that were offset by inventory adjustments of $3.0 million. During the third quarter 2018, the Company adjusted goodwill by $0.8 million after finalizing the valuation step up of property, plant and equipment of $5.5 million. The adjustment for property, plant and equipment was offset by completed technology intangible asset adjustments of $4.7 million.

During the first three quarters of 2018, the Company paid $15.9 million for inventory that was included in the initial purchase accounting. The payment was included within financing activities on the consolidated statements of cash flows.

The Company recorded $2.8 million and $17.3 million in cost of goods sold related to fair value inventory purchase accounting adjustments for the three and nine months ended September 30, 2018.

Goodwill related to the Codman Acquisition was allocated to the Codman Specialty Surgical segment. Goodwill is the excess of the consideration transferred over the net assets recognized and represents the expected revenue and cost synergies of the combined company and assembled workforce. Goodwill recognized as a result of this acquisition is generally deductible for income tax purposes.

In the fourth quarter of 2017, the Company wrote-off construction in progress of $6.3 million related to a project acquired as part of the Codman Acquisition that the Company decided to discontinue after the acquisition.

Divestiture to Natus

On September 8, 2017, to facilitate the acquisition of the Codman Neurosurgery Business and to comply with legal requirements, the Company and certain of its subsidiaries entered into an asset purchase agreement (the “Divestiture Agreement”) with Natus Medical Incorporated (“Natus”), pursuant to which the Company agreed to divest its global Camino® Intracranial Pressure monitoring product lines and the U.S. rights to its fixed pressure shunts business within its Codman Specialty Surgical segment together with certain neurosurgery assets acquired as part of the Codman Acquisition, which includes Codman U.S. dural graft implant, external ventricular drainage catheter and cerebrospinal fluid collection systems businesses (the “Divestiture”). The Divestiture Agreement was entered into in connection with the review of the Codman Acquisition by the Federal Trade Commission and the antitrust authority of Spain.

On October 6, 2017, upon the terms and subject to the conditions of the Divestiture Agreement, the Divestiture was completed and Natus paid an aggregate purchase price of $46.4 million.

Assets and liabilities divested consisted of the following as of October 6, 2017 (amounts in thousands):

Inventories

$

8,348

Prepaid expenses and other current assets

36

Assets held for sale

30,813

Property, plant and equipment, net

1,122

Goodwill

2,861

Total assets divested

$

43,180

Deferred revenue

$

1,082

Accrued compensation

209

Total liabilities divested

$

1,291

The transitional supply agreement with Natus requires the Company to provide to Natus certain assets defined in the transitional supply agreement upon termination. The Company recognized a liability of $1.3 million, included in other liabilities in the consolidated balance sheet, related to estimated cost of assets to be provided to Natus upon termination of the transitional supply agreement.

The Divestiture does not represent a strategic shift that will have a major effect on the Company's operations and financial statements. Goodwill was allocated to the assets and liabilities divested using the relative fair value method. In the fourth quarter of 2017, the Company recognized a pretax gain on sale of business of $2.6 million included in other income, net in its consolidated statement of operations for the year ended December 31, 2017.

Derma Sciences

On February 24, 2017, the Company executed the Agreement and Plan of Merger (the "Merger Agreement") under which the Company acquired all of the outstanding shares of Derma Sciences, Inc., a Delaware corporation ("Derma Sciences") for an aggregate purchase price of approximately $210.8 million, including payment of certain of Derma Sciences' closing expenses and settlement of stock-based compensation plans of $4.8 million and $4.3 million, respectively. The purchase price consisted of a cash payment to the former stockholders of Derma Sciences of approximately $201.7 million upon the closing of the transaction.

Derma Sciences is a tissue regeneration company focused on advanced wound and burn care that offers products to help manage chronic and hard-to-heal wounds, especially those resulting from diabetes and poor vascular functioning.

The revenue and the net income or loss attributable to this acquisition cannot be identified on a stand-alone basis because it has been integrated into the Company's operations.

The Derma Sciences acquisition was accounted for using the acquisition method of business combination under ASC 805, Business Combinations. This method requires that assets acquired and liabilities assumed in a business combination be recognized at their fair values as of the acquisition date.

The following table summarizes the final fair values of the assets acquired and liabilities assumed at the acquisition date and reflects purchase accounting adjustments subsequent to the acquisition date:

Goodwill related to the Derma Sciences acquisition was allocated to the Orthopedics and Tissue Technologies segment. Goodwill is the excess of the consideration transferred over the net assets recognized and represents the expected revenue and cost synergies of the combined company and assembled workforce. Goodwill recognized as a result of this acquisition is not deductible for income tax purposes. During the first quarter of 2018, the Company completed its purchase accounting of Derma Sciences.

Short-term Investments

Short-term investments recognized at the acquisition date of Derma Sciences are investments in equity and debt securities including certificates of deposit purchased with an original maturity greater than three months which are deposited in various U.S. financial institutions and are fully insured by the Federal Deposit Insurance Corporation. The Company considers securities with original maturities of greater than 90 days to be available for sale securities. Securities under this classification are recorded at fair value and unrealized gains and losses are recorded within accumulated other comprehensive income. The estimated fair value of the available for sale securities is determined based on quoted market prices. The Company evaluates securities with unrealized losses to determine whether such losses, if any, are other than temporary. Short-term investments are classified as Level 1 in fair value hierarchy. Fair values of short-term investments are determined using the unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the balance sheet date.

In the second quarter of 2017, the Company sold the acquired short-term investments and recognized a loss of $2.3 million included in other income (expense), net in the consolidated statement of operations.

Deferred Taxes

The acquired deferred taxes of $14.5 million include a deferred tax asset of $39.7 million related to a federal net operating loss which the Company expects to utilize against income in future periods and a deferred tax asset of $16.4 million related to intangibles acquired by Derma Sciences in previous periods, offset by a deferred tax liability of $41.1 million for new intangibles for which the Company will not receive a tax benefit and a deferred tax liability of $0.5 million related to various deferred items. In the second quarter of 2017, the Company decreased the preliminary estimated value of this deferred tax liability by $1.5 million to reflect the adjustments to preliminary estimated fair values of assets and liabilities acquired. In the fourth quarter of 2017, the Company decreased the preliminary value of the deferred tax asset by $3.3 million to reflect returns filed for periods prior to the acquisition date and adjustments for expected effective state tax rates.

On June 22, 2015, the FDA issued an Untitled Letter (the "Untitled Letter") alleging that BioD LLC's ("BioD") morselized amniotic membrane-based products do not meet the criteria for regulation as human cellular tissue-based products (“HCT/Ps”) solely under Section 361 of the Public Health Service Act and that, as a result, BioD would need a biologics license to lawfully market those morselized products. Since the issuance of the Untitled Letter, BioD and more recently, the Company, has been in discussions with the FDA to communicate its disagreement with the FDA’s assertion that certain products do not fall within the HCT/Ps. The FDA has not changed its position that certain of the BioD acquired products are not eligible for marketing solely under Section 361.

In November 2017, the FDA issued its final guidance document related to human tissue titled, “Regulatory Considerations for Human Cells, Tissues, and Cellular and Tissue-Based Products: Minimal Manipulation and Homologous Use” (the “HCT/P Final Guidance”). The HCT/P Final Guidance maintains the FDA’s position that products such as the Company’s morselized amniotic membrane tissue based products do not meet the criteria for regulation solely as HCT/Ps. In addition, the FDA articulated a risk-based approach to enforcement and, while some uses for amniotic membrane tissue-based products would enjoy as much as thirty-six months of enforcement discretion, other high risk uses could be subject to immediate enforcement action. The Company does not believe the uses for its amniotic membrane tissue based products fall into the high-risk category. Nonetheless, the Company can make no assurances that the FDA will continue to exercise its enforcement discretion with respect to the Company’s amniotic membrane tissue based products, and any potential action of the FDA could have a financial impact regarding the sales of such products. The Company has been considering and continues to consider regulatory approval pathways for its amniotic membrane tissue-based products. Revenues from BioD morselized amniotic material based products for the three and nine months ended September 30, 2018 and 2017 were less than 1.0% of consolidated revenues.

Contingent Consideration

The Company assumed contingent consideration incurred by Derma Sciences related to its acquisitions of BioD and the intellectual property related to the Medihoney product. The Company accounted for the contingent liabilities by recording their fair value on the date of the acquisition based on a discounted cash-flow model. The contingent liabilities recognized as part of the Derma Sciences acquisition relate to the following:

i.

contractual incentive payments that could be made to former equity owners of BioD if net sales of BioD products exceed a certain amount for the twelve-month periods ending June 30, 2017 and 2018 ("BioD Earnout Payments");

ii.

a contractual incentive payment that could be made to the former equity owners if there has been no specific enforcement action or notice by the FDA against the specific BioD products as a result of the Untitled Letter for a certain period after closing as defined by the agreement ("Product Payment"); and

iii.

contractual incentive payments that could be made to the former owner of the intellectual property relating to the Medihoney product line, if net sales of Medihoney products exceed certain amounts defined in the agreement between Derma Sciences and the former owner of the intellectual property of Medihoney for any twelve-month period ("Medihoney Earnout Payments").

At the date of the acquisition, net sales used in estimating the BioD Earnout Payments was based on the weighted average of different possible scenarios using a revenue volatility of 13.5%. The BioD Earnout Payments were valued using a discount rate of 3.0%. The maximum payout related to the BioD Earnout Payments is $26.5 million. The estimated fair value as of February 24, 2017 was $9.1 million. In August 2017, the Company paid $4.8 million for the twelve-month period ending June 30, 2017 component of the BioD Earnout Payments. The Company made no additional payments after the final earn out period. As of December 31, 2017, the estimated fair value of the BioD Earnout Payments was $0.3 million.

At the date of acquisition, the Company estimated that the probability of the Product Payment was 98.0% and valued it at a discount rate of 2.5%. The maximum payout related to the Product Payment is $29.7 million. The estimated fair value as of February 24, 2017 was $26.8 million. In the second quarter of 2017, the Company adjusted the preliminary estimated fair value to increase the Product Payment by $0.9 million related to additional products that should have been included in the preliminary estimate based on the Merger Agreement. On May 25, 2017, the Company made full payment for the Product Payment of $26.6 million. The payment was included in cash used in business acquisition, net of cash acquired within investing activities in the condensed consolidated statements of cash flows since the payment was made shortly after the acquisition.

At the date of the acquisition, the net sales used in estimating the Medihoney Earnout Payments were based on the weighted average of different possible scenarios using revenue volatility of 27.5%. The Medihoney Earnout Payments were valued using a discount rate of 4.5%. The maximum payout related to the Medihoney Earnout Payments is $5.0 million. During the second

quarter of 2018, the Company paid $2.0 million for the Medihoney Earnout Payment. The estimated fair value as of September 30, 2018 was $0.2 million. The estimated fair value as of February 24, 2017 and December 31, 2017 was $1.4 million.

These fair value measurements were based on significant inputs not observed in the market and thus represented a Level 3 measurement. The contingent considerations are re-measured to fair value at each reporting date until the contingency is resolved, and those changes in fair value are recognized in earnings. Depending on the expected timing of the estimated payments, the acquisition date fair values and subsequent remeasurement could change.

Pro Forma Results

The following unaudited pro forma financial information summarizes the results of operations for the three and nine months ended September 30, 2017 as if the acquisitions of Codman Neurosurgery and Derma Sciences and the divestiture to Natus, which were completed by the Company during 2017, had been completed as of the beginning of 2016. The pro forma results are based upon certain assumptions and estimates, and they give effect to actual operating results prior to the acquisitions and adjustments to reflect (i) the change in interest expense, depreciation expenses, intangible asset amortization and inventory step-up, (ii) timing of recognition for certain expenses that will not be recurring in a post-acquisition period, which includes $2.9 million incurred by Derma Sciences prior to the acquisition and $2.4 million and $14.4 million incurred by Integra, for the three and nine months ended September 30, 2017, and (iii) income taxes at a rate consistent with the Company’s statutory rate at the date of the acquisitions. No effect has been given to other cost reductions or operating synergies. As a result, these pro forma results do not necessarily represent results that would have occurred if the acquisition had taken place on the basis assumed above, nor are they indicative of the results of future combined operations.

Three Months Ended September 30,

Nine Months Ended September 30,

2017

2017

(In thousands, except per share amounts)

Total revenue

$

352,351

$

1,059,889

Net income

$

1,385

$

24,064

Basic income per share

$

0.02

$

0.32

3. REVENUES FROM CONTRACTS WITH CUSTOMERS

Summary of Accounting Policies on Revenue Recognition

Revenue is recognized upon the transfer of control of promised products or services to the customers in an amount that reflects the consideration the Company expects to receive in exchange for those products and services.

Total revenue, net, includes product sales, product royalties and other revenues, such as fees received from services.

For products shipped with FOB shipping point terms, the control of the product passes to the customer at the time of shipment. For shipments in which the control of the product is transferred when the customer receives the product, the Company recognizes revenue upon receipt by the customer. Certain products that the Company produces for private label customers have no alternative use and the Company has a right of payment for performance to date. Revenues from those products are recognized over the period that the Company manufactures these products, which is typically one to three months. The Company uses the input method to measure the manufacturing activities completed to date, which depicts the progress of the Company's performance obligation of transferring control of goods being manufactured for private label customers.

A portion of the Company's product revenue is generated from consigned inventory maintained at hospitals and distributors, and also from inventory physically held by field sales representatives. For these types of products sales, the Company retains control until the product has been used or implanted, at which time revenue is recognized.

Revenues from sale of products and services are evidenced by either a contract with the customer or a valid purchase order and an invoice which includes all relevant terms of sale. For product sales, invoices are generally issued upon the transfer of control (or upon the completion of the manufacturing in the case of the private label transactions recognized over time) and are typically payable 30 days after the invoice date. The Company performs a review of each specific customer's creditworthiness and ability to pay prior to acceptance as a customer. Further, the Company performs periodic reviews of its customers' creditworthiness prospectively.

Performance Obligations

The Company's performance obligations consist mainly of transferring control of goods and services identified in the contracts, purchase orders, or invoices. The Company has no significant multi-element contracts with customers.

Usage-based royalties and licenses are estimated based on the provisions of contracts with customers and recognized in the same period that the royalty-based products are sold by the Company's strategic partners. The Company estimates and recognizes royalty revenue based upon communication with licensees, historical information, and expected sales trends. Differences between actual reported licensee sales and those that were estimated are adjusted in the period in which they become known, which is typically the following quarter. Historically, such adjustments have not been significant.

The Company estimates returns, price concessions, and discount allowances using the expected value method based on historical trends and other known factors. Rebate allowances are estimated using the most likely method based on each customer contract.

The Company's return policy, as set forth in its product catalogs and sales invoices, requires the Company to review and authorize the return of a product in advance. Upon the authorization, a credit will be issued for the goods returned within a set amount of days from the shipment, which is generally ninety days.

The Company disregards the effects of a financing component if the Company expects, at contract inception, that the period between the transfer and customer payment for the good or services will be one year or less. The Company has no significant revenues recognized on payments expected to be received more than one year after the transfer of control of products or services to customers.

Contract Asset and Liability

Revenues recognized from the Company's private label business that are not invoiced to the customers as a result of recognizing revenue over time are recorded as a contract asset included in the prepaid expenses and other current assets account in the consolidated balance sheet.

Other operating revenues may include fees received under service agreements. Non-refundable fees received under multiple-period service agreements are recognized as revenue as the Company satisfies the performance obligations to the other party. A portion of the transaction price allocated to the performance obligations to be satisfied in the future periods is recognized as contract liability.

The following table summarized the changes in the contract asset and liability balances for the nine months ended September 30, 2018:

Contract Asset

Contract asset, January 1, 2018

$

3,552

Transferred to trade receivable of contract asset included

in beginning of the year contract asset

(3,552

)

Contract asset, net of transferred to trade receivables on contracts during the period

3,068

Contract asset, September 30, 2018

$

3,068

Contract Liability

Contract liability, January 1, 2018

$

11,059

Recognition of revenue included in beginning of year contract liability

(4,356

)

Contract liability, net of revenue recognized on contracts during the period

4,259

Foreign currency translation

(30

)

Contract liability, September 30, 2018

$

10,932

At September 30, 2018, the short-term portion of the contract liability of $3.6 million and the long-term portion of $7.3 million were included in accrued expenses and other current liabilities and other liabilities in the consolidated balance sheet.

As of September 30, 2018, the Company is expected to recognize revenue of approximately $1.1 million for the remainder of 2018, $2.8 million in 2019, $2.1 million in 2020, $1.3 million in 2021, $0.8 million in 2022, and $2.8 million thereafter.

Shipping and Handling Fees

The Company elected to account for shipping and handling activities as a fulfillment cost rather than a separate performance obligation. Amounts billed to customers for shipping and handling are included as part of the transaction price and recognized as revenue when control of underlying products is transferred to the customer. The related shipping and freight charges incurred by the Company are included in the cost of goods sold.

Certain of the Company's medical devices, including monitoring systems and neurosurgical systems, are designed to operate over long periods of time. These products are sold with warranties which may extend for up to two years from the date of purchase. The warranties are not considered a separate performance obligation. The Company estimates its product warranties using the expected value method based on historical trends and other known factors. The Company includes them in accrued expenses and other current liabilities in the consolidated balance sheet.

Taxes Collected from Customers

The Company elected to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the entity from a customer.

Disaggregated Revenue

The following table presents revenues disaggregated by the major sources of revenues for the three and nine months ended September 30, 2018 (amounts in thousands):

Three Months Ended September 30, 2018

Three Months Ended September 30, 2017

Nine Months Ended September 30, 2018

Nine Months Ended September 30, 2017

(amounts in thousands)

Neurosurgery

$

171,680

95,887

$

509,166

276,574

Precision Tools and Instruments

67,355

$

68,873

205,488

$

204,333

Total Codman Specialty Surgical

239,035

164,760

714,654

480,907

Wound Reconstruction and Care

78,290

69,667

225,003

194,177

Extremity Orthopedics

22,706

22,912

71,244

71,193

Private Label

25,823

21,495

78,225

73,357

Total Orthopedics and Tissue Technologies

126,819

114,074

374,472

338,727

Total revenue

$

365,854

$

278,834

$

1,089,126

$

819,634

See Note 14, Segment and Geographical Information, for details of revenues based on the location of the customer.

Effect of Adoption of ASC Topic 606

On January 1, 2018, the Company adopted Topic 606 using the modified retrospective method applied to all contracts which were not completed as of January 1, 2018. Results of operations for the reporting periods after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with Topic 605, Revenue Recognition.

The adoption of Topic 606 resulted in an increase to the opening retained earnings of $1.9 million, which was recorded net of taxes as of January 1, 2018 to reflect the change in timing of the recognition of revenue related to the Company's private label business from point in time to over time during the manufacturing process and goods in transit for which control was transferred to customers at the time of shipment. The total assets and liabilities increased by $7.1 million and $5.2 million, respectively, as of January 1, 2018.

The impact of adoption of Topic 606 to the Company's consolidated statement of operations for the three and nine months ended September 30, 2018 was as follows:

The Company tests goodwill and intangible assets with indefinite lives for impairment annually in the third quarter in accordance with ASC Topic 350. Additionally, the Company may perform interim tests if an event occurs or circumstances change that could potentially reduce the fair value of a reporting unit or indefinite lived intangible asset below its carrying amount. The carrying value of each reporting unit is determined by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units.

The Company tests goodwill for impairment by either performing a qualitative evaluation or a quantitative test. The qualitative evaluation is an assessment of factors, including reporting unit specific operating results as well as industry, market and general economic conditions, to determine whether it is more likely than not that the fair values of a reporting unit is less than its carrying amount, including goodwill. The Company may elect to bypass this qualitative assessment for some or all of its reporting units and perform a quantitative test.

For goodwill, the Company elected to bypass the qualitative assessment for its three reporting units and perform a quantitative test during the third quarter of 2018. In performing this test, the Company utilized a discount rate of 9.0%. The assumptions used in evaluating goodwill for impairment are subject to change and are tracked against historical results by management. Based on the results of this quantitative test, the Company recorded no impairment of goodwill.

For intangible assets with indefinite lives, the Company elected to bypass the qualitative assessment for its Codman Tradename intangible asset and perform a quantitative test during the third quarter 2018. In performing this test, the Company utilized a discount rate of 13.0%. The assumptions used in evaluating the Codman Tradename for impairment are subject to change and are tracked against historical results by management. Based on the results of the quantitative test, the Company recorded no impairment to the Codman Tradename intangible asset.

Definite Lived Intangible Assets

Product rights and other definite-lived intangible assets are tested periodically for impairment in accordance with ASC Topic 360 when events or changes in circumstances indicate that an asset’s carrying value may not be recoverable. The impairment testing involves comparing the carrying amount of the asset or asset group to the forecasted undiscounted future cash flows. In the event the carrying value of the asset exceeds the undiscounted future cash flows, the carrying value is considered not recoverable and an impairment exists. An impairment loss is measured as the excess of the asset’s carrying value over its fair value, calculated using discounted future cash flows. The computed impairment loss is recognized in the period that the impairment occurs.

During the third quarter of 2018, the Company recorded an impairment charge of $4.9 million in cost of goods sold related to completed technology assets acquired from Koby Ventures II, L.P dba Metasurg ("Metasurg Technology") due to recent contract negotiations and revised future projections. The remaining net book value of these intangible assets total $2.3 million as of September 30, 2018. Metasurg Technology is included in the Orthopedic and Tissue Technology segment. Of the total impairment charge of $4.9 million, $2.5 million was related to an out-of-period adjustment included in the three and nine months ended September 30, 2018. The out-of-period adjustment is attributed to the timing of performing the impairment test based on the contract termination associated with the intangible asset. The Company determined that the adjustment was not material to the consolidated financial statements for any previously reported annual or interim period and the adjustment to correct the misstatements is not material to the three or nine months ended September 30, 2018.

During the third quarter of 2017, the Company recorded an impairment charge of $3.3 million in cost of goods sold related to completed technology assets acquired from Tarsus Medical, Inc. ("Tarsus Technology"), since the underlying product will no longer be sold. Tarsus Technology was included in the Orthopedic and Tissue Technology segment.

Based on quarter-end exchange rates, annual amortization expense (including amounts reported in cost of product revenues, but excluding any possible future amortization associated with acquired IPR&D) is expected to be approximately $71.6 million in 2018, $66.4 million in 2019, $66.2 million in 2020, $65.2 million in 2021, $61.7 million in 2022, $60.8 million in 2023 and $599.3 million thereafter. Identifiable intangible assets are initially recorded at fair market value at the time of acquisition using an income or cost approach.

6. DEBT

Amended and Restated Senior Credit Agreement

On May 3, 2018, the Company entered into the fifth amendment and restatement (the "May 2018 Amendment") of its Senior Credit Facility (the "Senior Credit Facility") with a syndicate of lending banks with Bank of America, N.A., as Administrative Agent. The May 2018 Amendment extended the maturity date to May 3, 2023 and decreased the applicable rate, as described below. The Company continues to have the aggregate principal amount of $2.2 billion available to it through the following facilities:

i.

a $900.0 million Term Loan facility; and

ii.

a $1.3 billion revolving credit facility, which includes a $60.0 million sublimit for the issuance of standby letters of credit and a $60.0 million sublimit for swingline loans.

In connection with the May 2018 Amendment, the Company’s maximum consolidated total leverage ratio in the financial covenants (as defined in the Senior Credit Facility) was modified to the following:

Fiscal Quarter

Maximum Consolidated Total Leverage Ratio

Execution of May 2018 Amendment through March 31, 2019

5.50 : 1.00

June 30, 2019 through March 31, 2020

5.00 : 1.00

June 30, 2020 through March 31, 2021

4.50 : 1.00

June 30, 2021 and thereafter

4.00 : 1.00.

Borrowings under the Senior Credit Facility bear interest, at the Company’s option, at a rate equal to the following:

i.

the Eurodollar Rate (as defined in the Senior Credit Facility) in effect from time to time plus the applicable rate (ranging from 1.00% to 1.75%), or

ii.

the highest of:

1.

the weighted average overnight Federal funds rate, as published by the Federal Reserve Bank of New York, plus 0.50%, plus the applicable rate (ranging from 0% to 0.75%),

2.

the prime lending rate of Bank of America, N.A. plus the applicable rate (ranging from 0% to 0.75%), and

The applicable rates are based on the Company’s consolidated total leverage ratio (defined as the ratio of (a) consolidated funded indebtedness less cash that is not subject to any restriction on the use or investment thereof to (b) consolidated EBITDA at the time of the applicable borrowing).

The Company will pay an annual commitment fee ranging from 0.15% to 0.30%, based on the Company's consolidated total leverage ratio, on the amount available for borrowing under the revolving credit facility.

The Senior Credit Facility is collateralized by substantially all of the assets of the Company’s U.S. subsidiaries, excluding intangible assets. The Senior Credit Facility is subject to various financial and negative covenants and at September 30, 2018, the Company was in compliance with all such covenants. The Company capitalized $0.5 million of incremental financing costs in 2017 in connection with modifications to the Senior Credit Facility. In connection with the May 2018 Amendment, the Company capitalized

$4.2 million of financing costs and wrote off $0.8 million of previously capitalized financing costs during the second quarter of 2018.

In October 2017, the Company capitalized $19.1 million of incremental financing costs related to the drawing of the Term Loan A-1 component of the Senior Credit Facility.

At September 30, 2018 and December 31, 2017, there were $545.0 million and $655.0 million outstanding, respectively, under the revolving credit component of the Senior Credit Facility at weighted average interest rates of 3.8% and 3.7%, respectively. At September 30, 2018 and December 31, 2017, there were $900.0 million and $1.2 billion outstanding, respectively, under the Term Loan component of the Senior Credit Facility at weighted average interest rates of 3.7% and 3.6%, respectively. At September 30, 2018, there was approximately $754.4 million available for borrowing under the Senior Credit Facility. At September 30, 2018, $11.3 million of the Term Loan component of the Senior Credit Facility is classified as current on the consolidated balance sheet.

The fair value of outstanding borrowings of the Senior Credit Facility's revolving credit and Term Loan components at September 30, 2018 was approximately $524.1 million and, $875.4 million, respectively. These fair values were determined by using a discounted cash flow model based on current market interest rates available to the Company. These inputs are corroborated by observable market data for similar liabilities and therefore classified within Level 2 of the fair value hierarchy. Level 2 inputs represent inputs that are observable for the asset or liability, either directly or indirectly, and are other than active market observable inputs that reflect unadjusted quoted prices for identical assets or liabilities.

Letters of credit outstanding as of September 30, 2018 and December 31, 2017 totaled $0.6 million. There were no amounts drawn as of September 30, 2018.

Contractual repayments of the Term Loan component of the Senior Credit Facility are due as follows:

Year Ended December 31,

Principal Repayment

(In thousands)

Remainder of 2018

$

—

2019

22,500

2020

45,000

2021

56,250

2022

67,500

2023

708,750

$

900,000

The outstanding balance of the revolving credit component of the Senior Credit Facility is due on May 3, 2023.

7. DERIVATIVE INSTRUMENTS

Interest Rate Hedging

The Company’s interest rate risk relates to U.S. dollar denominated variable interest rate borrowings. The Company uses interest rate swap derivative instruments to manage earnings and cash flow exposure resulting from changes in interest rates. These interest rate swaps apply a fixed interest rate on a portion of our expected LIBOR-indexed floating-rate borrowings. The Company held the following interest rate swaps as of September 30, 2018 (amounts in thousands):

The Company has designated these derivative instruments as cash flow hedges. The Company assesses the effectiveness of these derivative instruments and has recorded the changes in the fair value of the derivative instrument designated as a cash flow hedge as unrealized gains or losses in accumulated other comprehensive income (“AOCI”), net of tax, until the hedged item affected earnings, at which point any gain or loss was reclassified to earnings. If the hedged cash flow does not occur, or if it becomes probable that it will not occur, the Company will reclassify the remaining amount of any gain or loss on the related cash flow hedge recorded in AOCI to interest expense at that time. On October 10, 2018, the Company entered into additional interest rate swap derivative instruments designated as cash flow hedges with a total notional amount of $225.0 million.

Foreign Currency Hedging

From time to time the Company enters into foreign currency hedge contracts intended to protect the U.S. dollar value of certain forecasted foreign currency denominated transactions. The Company assesses the effectiveness of the contracts that are designated as hedging instruments. The changes in fair value of foreign currency cash flow hedges are recorded in AOCI, net of tax, until the hedged item affects earnings. Once the related hedged item affects earnings, the Company reclassifies amounts recorded in AOCI to earnings. If the hedged forecasted transaction does not occur, or if it becomes probable that it will not occur, the Company will reclassify the amount of any gain or loss on the related cash flow hedge to earnings at that time. For contracts not designated as hedging instruments, the changes in fair value of the contracts are recognized in other income (expense), net in the consolidated statements of operation, along with the offsetting foreign currency gain or loss on the underlying assets or liabilities.

The success of the Company’s hedging program depends, in part, on forecasts of certain activity denominated in foreign currency. The Company may experience unanticipated currency exchange gains or losses to the extent that there are differences between forecasted and actual activities during periods of currency volatility. In addition, changes in currency exchange rates related to any unhedged transactions may affect earnings and cash flows.

On November 28, 2017, the Company entered into a foreign currency forward contract, with a notional amount of $8.9 million, to mitigate the foreign currency exchange risk related to a certain intercompany loan denominated in Swiss Francs ("CHF"). The contract is not designated as a hedging instrument. For the three and nine months ended September 30, 2018, the Company recognized a $0.2 million loss from the change in fair value of the contract, which was included in other income (expense), net in the consolidated statement of operations. The foreign currency forward contract was settled on September 28, 2018.

Cross-Currency Rate Swap

On October 2, 2017, the Company entered into cross-currency swap agreements to convert a notional amount of $300.0 million equivalent to 291.2 million of CHF denominated intercompany loans into U.S. dollars. The CHF-denominated intercompany loans were the result of the purchase of intellectual property by a subsidiary in Switzerland as part of the Codman Acquisition. The objective of these cross-currency swaps is to reduce volatility of earnings and cash flows associated with changes in the foreign currency exchange rate. Under the terms of these contracts, which have been designated as cash flow hedges, the Company will make interest payments in Swiss Francs and receive interest in U.S. dollars. Upon the maturity of these contracts, the Company will pay the principal amount of the loans in Swiss Francs and receive U.S. dollars from the counterparties.

The Company held the following cross-currency rate swaps as of September 30, 2018 (dollar amounts in thousands):

The cross-currency swaps were carried on the consolidated balance sheet at fair value, and changes in the fair values were recorded as unrealized gains or losses in AOCI. For the three and nine months ended September 30, 2018, the Company recorded a loss of $2.6 million and gain of $2.2 million in other income (expense), net for the foreign currency rate translation to offset the gains or losses recognized on the intercompany loans. For the three and nine months ended September 30, 2018, the Company recorded losses of $3.1 million and gains of $3.0 million in AOCI related to the change in fair value of the cross-currency swap and gains of $1.9 million and $5.9 million in other income, net included in the consolidated statements of operations related to the interest rate differential of the cross-currency swap. As of September 30, 2018, an estimated gain of $7.6 million is expected to be reclassified within the next twelve months to other income, net from AOCI. As of September 30, 2018, the Company does not expect any gains or losses will be reclassified into earnings as a result of the discontinuance of these cash flow hedges because the original forecasted transaction will not occur.

Counterparty Credit Risk

The Company manages its concentration of counterparty credit risk on its derivative instruments by limiting acceptable counterparties to a group of major financial institutions with investment grade credit ratings, and by actively monitoring their credit ratings and outstanding positions on an ongoing basis. Therefore, the Company considers the credit risk of the counterparties to be low. Furthermore, none of the Company’s derivative transactions is subject to collateral or other security arrangements, and none contain provisions that depend upon the Company’s credit ratings from any credit rating agency.

The Company has classified all of its derivative instruments within Level 2 of the fair value hierarchy because observable inputs are available for substantially the full terms of the derivative instruments. The fair value of the interest rate swaps and the cross-currency swaps was developed using a market approach based on publicly available market yield curves and the terms of the related swap. The Company performs ongoing assessments of counterparty credit risk.

The following table summarizes the fair value and presentation for derivatives designated as hedging instruments in the condensed consolidated balance sheets as of September 30, 2018 and December 31, 2017:

Fair Value as of

Location on Balance Sheet (1):

September 30, 2018

December 31, 2017

(In thousands)

Derivatives designated as hedges — Assets:

Prepaid expenses and other current assets

Interest rate swap(2)

$

6,682

$

1,521

Cross-currency swap

7,603

7,757

Other assets

Interest rate swap(2)

20,246

2,491

Total derivatives designated as hedges — Assets

$

34,531

$

11,769

Derivatives designated as hedges — Liabilities:

Accrued expenses and other current liabilities

Interest rate swap(2)

$

—

$

1,845

Other liabilities

Interest rate swap(2)

—

1,575

Cross-currency swap

14,466

11,714

Total derivatives designated as hedges — Liabilities

$

14,466

$

15,134

(1)

The Company classifies derivative assets and liabilities as non-current based on the cash flows expected to be incurred within the following 12 months.

(2)

At September 30, 2018 and December 31, 2017, the notional amount related to the Company’s interest rate swaps was $1.05 billion. The notional amount will be reduced by $150.0 million in June 2019.

The following presents the effect of derivative instruments designated as cash flow hedges on the accompanying condensed consolidated statement of operations during the three and nine months ended September 30, 2018 and 2017:

Balance in AOCI

Beginning of

Quarter

Amount of

Gain (Loss)

Recognized in

AOCI

Amount of Gain (Loss)

Reclassified from

AOCI into

Earnings

Balance in AOCI

End of Quarter

Location in

Statements of

Operations

(In thousands)

Three Months Ended September 30, 2018

Interest rate swap

$

22,344

$

5,059

$

473

$

26,930

Interest (expense)

Cross-currency swap

(7,892

)

(3,067

)

(707

)

(10,252

)

Other income (expense)

$

14,452

$

1,992

$

(234

)

$

16,678

Three Months Ended September 30, 2017

Interest rate swap

$

935

$

297

$

(63

)

$

1,295

Interest (expense)

$

935

$

297

$

(63

)

$

1,295

Balance in AOCI

Beginning of

Year

Amount of

Gain (Loss)

Recognized in

AOCI-

Effective Portion

Amount of Gain (Loss)

Reclassified from

AOCI into

Earnings-Effective

Portion

Balance in AOCI

End of Quarter

Location in

Statements of

Operations

(In thousands)

Nine Months Ended September 30, 2018

Interest rate swap

$

592

$

26,307

$

(31

)

$

26,930

Interest (expense)

Cross-currency swap

(5,104

)

3,000

8,148

(10,252

)

Other income (expense)

$

(4,512

)

$

29,307

$

8,117

$

16,678

Nine Months Ended September 30, 2017

Interest rate swap

$

1,871

$

(618

)

$

(42

)

$

1,295

Interest (expense)

$

1,871

$

(618

)

$

(42

)

$

1,295

At September 30, 2018, the Company expects $14.3 million of pre-tax income recorded in AOCI related to cash flow hedges to be reclassified to earnings in the next twelve months.

Net Investment Hedges

The Company manages certain foreign exchange risks through a variety of strategies, including hedging. The Company is exposed to foreign exchange risk in its international operations from foreign currency purchases, net investments in foreign subsidiaries, and foreign currency assets and liabilities created in the normal course of business. On October 1, 2018, the Company entered into cross-currency swap agreements designated as net investment hedges to partially offset the effects of foreign currency on foreign subsidiaries. On the consummation date, the total notional amount of cross-currency swaps designated as net investment hedges was $354.5 million.

8. STOCK-BASED COMPENSATION

As of September 30, 2018, the Company had stock options, restricted stock awards, performance stock units, contract stock awards and restricted stock unit awards outstanding under two plans, the 2001 Equity Incentive Plan (the “2001 Plan”) and the 2003 Equity Incentive Plan (the “2003 Plan,” and collectively, the “Plans”).

Stock options issued under the Plans become exercisable over specified periods, generally within three to four years from the date of grant for officers and employees, and within a year from date of grant for directors and generally expire eight years from the grant date for employees, and from eight to ten years for directors and certain executive officers. Restricted stock issued under

the Plans vests over specified periods, generally three years after the date of grant. The vesting of performance stock issued under the Plans is subject to service and performance conditions.

Stock Options

As of September 30, 2018, there were approximately $4.8 million of total unrecognized compensation costs related to unvested stock options. These costs are expected to be recognized over a weighted-average period of approximately two years. There were 139,938 stock options granted during the nine months ended September 30, 2018.

Awards of Restricted Stock and Performance Stock

Performance stock and restricted stock awards generally have requisite service periods of three years. Performance stock units are subject to graded vesting conditions, and the Company expenses their fair value over the requisite service period. The Company expenses the fair value of restricted stock awards on a straight-line basis over the requisite service period. As of September 30, 2018, there were approximately $24.3 million of total unrecognized compensation costs related to these unvested awards. The Company expects to recognize these costs over a weighted-average period of approximately two years. The Company granted 266,354 restricted stock awards and 119,459 performance stock during the nine months ended September 30, 2018.

The Company has no formal policy related to the repurchase of stock for the purpose of satisfying stock-based compensation obligations.

The Company also maintains an Employee Stock Purchase Plan (the “ESPP”), which provides eligible employees with the opportunity to acquire shares of common stock at periodic intervals by means of accumulated payroll deductions. The ESPP is a non-compensatory plan based on its terms.

Net periodic benefit costs for the Company’s defined benefit pension plans for the three and nine months ended September 30, 2018 were $0.5 million and $1.7 million, respectively. The components of the net periodic benefit costs other than the service cost component of $0.7 million and $2.1 million for the three and nine months ended September 30, 2018, respectively, are included in other income (expense), net in the consolidated statements of operations.

The Company previously disclosed in its consolidated financial statements for the year ended December 31, 2017 that it expected to contribute $1.8 million to its defined benefit pension plans in 2018. For the nine months ended September 30, 2018, the Company contributed $1.1 million, to the defined benefit plans. As of September 30, 2018, the Company anticipates contributing an additional $0.9 million to its defined benefit plans in 2018, for a total of $2.0 million.

The estimated fair values of plan assets were $30.4 million and $26.9 million as of September 30, 2018 and December 31, 2017, respectively. The net plan assets of the pension plans are invested in common trusts as of September 30, 2018 and December 31, 2017. Common trusts are classified as Level 2 in the fair value hierarchy. The fair value of common trusts is valued at the net asset value based on the fair values of the underlying investments of the trusts as determined by the sponsor of the trusts. The investment strategy of the Company's defined benefit plans is both to meet the liabilities of the plans as they fall due and to maximize the return on invested assets within an appropriate risk profile.

10. TREASURY STOCK

On October 25, 2016, the Board of Directors terminated its October 2014 authorization for the repurchase of its outstanding common stock and authorized management to repurchase up to $150.0 million of its outstanding common stock through December 31, 2018. Shares may be repurchased either in the open market or in privately negotiated transactions. As of September 30, 2018, there remained $150.0 million available for repurchase under this authorization.

As of September 30, 2018 and December 31, 2017, there were 2.9 million shares of treasury stock outstanding with a cost of $120.7 million and $121.6 million, respectively, at a weighted average of $41.87 per share.

There were no cash treasury stock repurchases during the nine months ended September 30, 2018 or in 2017.

The following table provides a summary of the Company's effective tax rate:

Three Months Ended September 30,

Nine Months Ended September 30,

2018

2017

2018

2017

Reported tax rate

(20.6

)%

2.3

%

(8.4

)%

(27.6

)%

The Company’s effective income tax rates for the three months ended September 30, 2018 and 2017 were (20.6)% and 2.3%, respectively. For the three months ended September 30, 2018, in addition to the reduction of the federal statutory rate from 35% to 21% under the Tax Cuts and Jobs Act, the primary drivers of the reduction in the rate are the additional excess tax benefit of $2.1 million from share-based compensation and $1.1 million of foreign tax credits, partially offset by the inclusion of the new GILTI (as defined below) provisions of $0.8 million and other tax reform-related changes.

The Company's effective income tax rates for the nine months ended September 30, 2018 and 2017 were (8.4)% and (27.6)%, respectively. For the nine months ended September 30, 2018, the primary drivers of the higher tax rate were higher income before income taxes compared to the same period in 2017, and the inclusion of the new GILTI (as defined below) provisions of $2.2 million and other tax reform-related changes; offset in part, by the reduction in the federal statutory rate from 35% to 21% and additional foreign tax credits of $1.1 million. The nine months ended September 30, 2017 included an additional tax benefit of $1.9 million related to share-based compensation, when compared to the same period in 2018.

The Tax Cuts and Jobs Act (the "2017 Tax Act"), enacted in December 2017, made significant changes to the previous tax laws. Included among the numerous changes were a reduction of the federal statutory rate from 35% to 21%, limitations on the deductibility of interest expense and executive compensation, and the elimination of certain domestic tax deductions such as the domestic production activities deduction. Additionally, the 2017 Tax Act provided for a one-time repatriation tax on accumulated foreign subsidiaries’ untaxed foreign earnings (the “Toll Tax”).

The 2017 Tax Act implemented a territorial tax system and includes base erosion provisions on non-U.S. earnings, which subjects certain foreign earnings to additional taxation as global intangible low-taxed income (“GILTI”). These provisions became effective on January 1, 2018. As of September 30, 2018, the Company included GILTI related to current-year operations in its estimated annual effective tax rate. Pursuant to SAB 118, the Company has not yet determined whether GILTI should be a deferred tax item.

The 2017 Tax Act eliminated the deferral of U.S. income tax on unrepatriated earnings from foreign subsidiaries through the imposition of the Toll Tax, a one-time tax in 2017 on deemed repatriated foreign earnings, which is paid over an eight-year period. The tax is assessed on the foreign subsidiary accumulated foreign earnings that were not previously taxed. Foreign earnings in cash and cash equivalents are taxed at 15.5% and all other earnings are taxed at 8.0%. The calculation of the Toll Tax allows for the ability to offset positive foreign earnings with existing foreign deficits and use of foreign tax credits. The Company prepared a reasonable estimate of this tax and expects to continue to refine the estimate as it finalizes its 2017 tax returns. During 2017, the Company recorded an estimated income tax expense of $5.5 million related to the Toll Tax, of which, $4.6 million is expected to be paid within one year. The Company continued to analyze its foreign earnings and profits (“E&P”) during the nine months ended September 30, 2018 and has not made any adjustments to the provisional amounts recognized during 2017. The Company will continue to refine its E&P analysis, which may affect the measurement of the Toll Tax liability.

As a result of the 2017 Tax Act’s reduction of the federal statutory rate from 35% to 21%, the Company remeasured deferred tax assets and liability and recorded a tax benefit of $43.4 million as of December 31, 2017. The Company did not record any adjustments to this provisional amount during the nine months ended September 30, 2018 and will continue to analyze and refine its calculations related to the remeasurement as the impact of the 2017 Tax Act is finalized.

On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the 2017 Tax Act. The Company made reasonable estimates of the impact of the 2017 Tax Act on its consolidated financial statements as of December 31, 2017 and recognized the provisional tax impacts related to the deemed repatriated earnings and the revaluation of deferred tax assets and liabilities and included these amounts in its consolidated financial statements for the twelve months ended December 31, 2017. The ultimate impact may differ from these provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the 2017 Tax Act.